As I write this on May 31, 2010, the
world is a mess: We're still fighting two wars, and North Korea is on the
brink of another; there's a world financial crisis that worsens daily (our own
national debt has grown from 3.18 to 10.64 percent GDP between 2008 and 2010); and at
home, there's 10 percent unemployment and no end in sight to the massive oil
leak in the Gulf of Mexico. Having said that, most companies are lean and
mean with depleted inventories. Earnings continue to look good, and as a
consequence, the market has been on a tear: between the low on March 6, 2009 and
the high on April 29,2010, the S&P 500 gained 76.59 percent before selling off
11.39 percent this past month. Further, 52.6 percent of the 7,102 stocks
in the TC2000 data base exceeded the S&P's performance.
In this report, I’ll restate the conservative approach (1) to earning a 15 to 30
percent return on your money and (2) to buying quality stocks at big discounts
in price. Then offer new tips for today's volatile market. The strategy is built around
selling options (called “writing” options in option jargon): Naked Puts to
generate income or bargain stock purchases.
Before describing the strategy
in more detail, and adding a few selected tips for today's volatile market, let me describe what stock options are for those
of you that might have heard of them but never used them or, worse, for those of
you who think of them as extremely risky strategies.
What
are Options?
Options are simply contracts,
most controlling a 100-share block of their underlying vehicle which could be
stock shares or Exchange Traded Funds (ETFs). Once your brokerage account has
been properly activated, options are as easy to buy or sell as the stocks
themselves. However, for all but the most heavily traded stocks and ETFs, the
bid/ask spread of an option trade can be much wider than that of its underlying
vehicle. They just aren’t as liquid.
Today, one can buy or sell
(write) option contracts on over one-fourth of the stock universe, as well as
on most indices (as ETFs) and other ETF’s as well, e.g., country, sector
specific and even inverse ETFs. Each such vehicle has its own option string,
i.e., a number of different contracts differing in their time of expiration
and their strike price. All effectively expire on the third Friday of their
expiration month (technically on the Saturday). Most can be written for the
next several months, while some can be written years into the future (Leaps).
There are two basic types: Calls
and Puts. The value of a Call rises as the price of its underlying stock goes
up, while the value of a Put rises as the price of its underlying stock falls.
A whole arsenal of strategies can then be fashioned around simply buying and/or
selling Puts and Calls singly or in defined combinations, e.g.,writing
Naked Puts or Covered Calls, going Long Calls, writing or buying Debit and/or
Credit Spreads, etc .
Puts give the buyer of the
contract the right, though not the obligation, to sell to the Put seller (writer
of the contract) the underlying 100 shares of stock at any time up to its
expiration date at a specified price (the option’s strike price)—no matter what
the price of its underlying stock at the time of the sale. Conversely, Calls
give the buyer of the contract the right, but not the obligation to buy stock
from the seller of the Call’s contract at the contract’s strike price. For
these rights, sellers of either option type are paid a premium. Truthfully,
trading options is no more complicated than that, but two analogies should make
their usefulness clearer.
A Put’s Similarity to a Home’s Insurance Policy
A Put acts
like an insurance policy for the buyer in much the same way an insurance policy
protects your home. You, the homeowner (Put buyer) buy the insurance from the
insurance writer (Put writer) to protect against a catastrophic loss. The
insurance writer (like State Farm), on the opposite side of the transaction,
collects the premium and profits from insuring low-probability losses.
Sometimes a hurricane Ivan happens, but most times the insurance company sits
back, collects premium and grows rich (it’s been Warren Buffet’s road to
riches).
Back to Put options, the writer
of the Put is paid the option’s premium and, for doing so, guarantees the Put
buyer that he will buy the underling stock at an agreed upon price (the strike
price) at any time up to the option’s expiration date at the Put owner’s
discretion. The writer of the Put, in effect, writes an insurance policy for
the buyer of the Put: the seller gets the premium (income), and the buyer gets
the guarantee that his stock’s price can not fall below the option’s strike
price through the option’s expiration date.
For example, if stock XYZ were
trading at $50, and one purchased its $50 Put for $3—one that expired in three
months—the Put buyer’s betting that between now and three months from now XYZ
will finish below $47 before expiration. The writer of the Put, on the other
hand, thinks the underlying will hold its value or rise over the next three
months and just wants the $3 for income or, failing that, wants ultimately to
own XYZ {trading at $50 today} at the reduced price of $47 if he’s later forced
to buy. The buyer controls that $50 stock for three months at a fraction of its
value (just $3 versus $50). What makes this option trade more risky than
shorting the stock outright is that one effectively shorts at $47 a stock today
worth $50, but at the same time, less risky is that the total liability should
the stock rise say to $75 is again limited to the $3 premium (unlike the full
loss experienced by the short seller).
Typically, Puts serve two
purposes: (1) someone believes a stock’s price is ready to fall and wants to
trade that way, or (2) someone else is holding stock positions that he wants to
protect from a fall (i.e., they want to hedge their portfolio)—a kind of
insurance if you will. Those that write Puts do so for the income stream or as
a method to buy stocks tomorrow at a cheaper price than available today. It’s
these strategies that are developed in this report.
Calls give buyers the right, but
not the obligation, to buy a stock up to some specified point in the future at a
specified price. They are betting on a price rise in the underlying stock and
are leveraging their cost, while sellers again look to generate income. If the
seller already owns the stock on which he is writing Calls, the options are
commonly referred to as “Covered” Calls—perhaps the most conservative of all
option plays, it’s even available in most IRA accounts.
Now, let me add some prospective
to option buying and selling. Once you understand the probabilities involved in
trading options, you will look for strategies that involve selling options to
take advantage of the high likelihood for options to expire worthless.
A study analyzing three years of
data (1997-1999), compiled by the Chicago Mercantile Exchange, confirms that
option sellers are the winners over option buyers (John Summa, “Option Sellers
vs. Buyers: Who Wins?,” Futures Magazine, March 2003). His
study, based on the option characteristics of five commodity markets (S&P 500
index, Nasdaq 100 index, Eurodollar, Japanese yen, and live cattle), showed that
over this three-year period an average of 76.5 percent of all options expired
worthless. Even during this bull market period where prices were rising
greatly, 74.9 percent of all Call options expired worthless and 82.6 percent of
all Put options did likewise. Three patterns emerged from the study: (1) three
of four options held to expiration expired worthless; (2) the percentage of Puts
to Calls expiring worthless depended on the primary market trend; and (3) option
sellers were invariably the winners!
With that as an introduction, let’s see how one can mold these Puts into an effective income
strategy. You’ll notice that most calculations ignore commissions ($1 per
contract for me). Further, sells are conducted at bid prices and buys are
conducted at ask prices.
Tips on Writing Naked Puts in a Volatile
Market
Most successful
trading strategies are built around mean reversion where one
buys extreme weakness then sells into strength. While
statistics show this approach can be very successful, it
also tends to be accompanied by long periods of sitting on
cash waiting for those periods of extreme weakness to
develop. Over the past several months, I’ve written about a
strategy that can be used to deploy cash at higher rates of
return: writing out-of-the-money (OTM) Naked Puts. See,
for example:
Trading Options for Income ;
Allocating Money in the Market at Higher Rates of Return.
I’ll further discuss here a trading technique that puts cash
to work while waiting for that next trading window.
Writing Naked Puts, as a strategy, is more conservative than
just buying stocks. Consider, over the next 30 days, a
stock’s price can do one of five things: go up a lot, go up
a little, stay essentially the same, go down a little or go
down a lot. The stock owner profits in two of those
scenarios, while the Put writer makes money in four of the
five and still doesn’t lose as much as the stock owner in
the fifth when the “stock falls a lot.” Albeit, I admit,
the latter doesn’t make as much as the stock owner when the
stock goes up a lot. Having made that point, let me offer a
few tips on using this strategy in today’s volatile market.
Tip 1:
Write Puts on quality stocks that you wouldn’t mind owning
at substantially reduced prices;
Tip 2:
Make sure underlying stock’s price lies above its 200-day
moving average, as that’s an indication that this particular
stock’s price has not broken down and lost its institutional
support;
Tip 3:
Put premiums become richer in uncertain times, as people
rush to buy protective Puts, so one can write deeper OTM Puts and still get a targeted return, say 18 percent
annualized;
Tip 4:
In an uncertain, volatile market, trade smaller size, demand
greater downside protection, and prevent catastrophic losses
with a stop loss strategy, one based either on the
underlying stock’s price or the option premium itself (e.g.,
double the premium or a violation of the OTM Put’s strike
price, whichever occurs first);
Tip 5:
Trade liquid Puts with bid/ask spreads less than $0.25 in
case the trade goes against you and needs to be closed;
Tip 6:
Trade shorter time periods to reduce the risk of further
downturn and a potential stop-loss exit, e.g., instead of
writing 30-day front month Puts, write them over the last 15
days of the option’s life; realize though, if one required a
1.5 percent return over 30 days (~18 percent annually), he
or she still need to get the same 1.5 percent over the
shorter period as now there’s 15 days of dead time to
carry; Note, trading the last 15 days of an option’s life
is not equivalent to trading 15 days of a longer life option
then exiting early because if the market suddenly turns
down, volatility rises, premiums inflate and exiting a short OTM position becomes expensive;
Tip 7:
Be particularly aware of when the next earning’s report is
because premium inflates as that date approaches; further,
the risk of a post-report selloff increases in an edgy
market;
Tip 8:
Quality stocks that have pulled back are apt to bounce
higher quickly and significantly reduce the premium of a
short Put position; as soon as a short put position is
created, place a cover order that closes the order when the
remaining premium represents less than a seven percent
annualized return because that capital can be redeployed at
a higher rate of return.
An Example of TSM’s Short-Term Put Writing
Strategy
As an example of trading today’s volatile market, consider
BIDU, the provider of Chinese and Japanese internet search
services. Its great fundamentals are evidenced by top
rankings from several independent services: Value Line’s
Timeliness Ranking (1), Zacks Stock Rankings (1), IBD 100
membership, Morningstar Ranking (10) and a 1.38 VST (Value,
Safety and Timing) Vector Vest measure (35th of
10,000 rated stocks). Too, it has made TripleScreenMethod’s
(TSM) list for five of the last 28 weeks.
Even so, BIDU has substantial value left at its current
price with 0.65 and 0.75 PEG ratios based on the next two
year’s estimated earnings growth. Moreover, this year’s
earning’s estimates have been increased: upped 29.5 percent
in the last 90 days. By all accounts BIDU is a great stock
to trade, one that will have lots of institutional interest
at its major areas of support.
As shown in the Chart, this past May offered several
opportunities to write Puts when, in a volatile market, BIDU’s price fell to major areas of support (blue arrows
marking 5/6, 5/21 and 5/25) following a great earnings
report and gap up on 4/29 (horizontal arrow).
Table I details possible Naked Put trades. For example, on
5/6 BIDU was trading at $62.50 near the support of its
20-day moving average. Its $59 June Put (expiring in 44
days) could be written for $1.90 per share or its $55
strike, with its increased downside protection, at $0.95 a
share. Either strike falls well below BIDU’s 50-day moving
average which is the next likely area of support if price
should continue to fall. That first trade scenario
represents a 28.39 percent annualized return if held to
expiration and an additional 8.64 percent downside
protection from the current price. The second trade
represents a 14.68 percent annualized return with 13.52%
downside protection.
Note, the percent annualized return calculations used here
assume that each position would be 100 percent
collateralized as would be required for an IRA account,
e.g., $5,710 ($5,900 - $190) would be frozen in the
brokerage account as collateral for each contract in case a
potential buy was necessary should the BIDU shares actually
be put to the Naked Put writer.
But this trade didn’t need to be held to expiration. Just
seven days later, price rose to $82.29, and the short Put
positions could be closed for $0.40 and $0.25,
respectively. These amounts represented 6.61 and 4.34
percent returns if the position had been held from that
point until expiration 37 days later. Of course, at this
point our cash collateral could be better used
collateralizing a different position.
Short-term BIDU trades presented themselves again on 5/21
and 5/25 and similarly could have been closed shortly
thereafter (each within three days) for substantial gains.
Obviously, in to today’s volatile market, it can pay to
manage short Put positions instead of just putting on one
and holding it until expiration. In the BIDU $59 strike
series of trades, we increased our profit from $1.90 per
share to $3.70 ($1.90 – 0.40 + 1.65 – 0.65 + 1.60 – 0.40)
and, at the same time, reduced our exposure to the volatile
market’s risk from 44 to 13 days. That’s a 6.69 percent
return ($370/($5,900-$370)) for each contract (or 187.9
percent annualized) earned on money while one waits for the
next great stock buying opportunity.
Most evenings TSM’s daily report provides a list of Puts
available for TSM stocks that met the 18 percent annualized
return and 15 percent downside protection at the prior day’s
close. These screening criteria lessen as expiration draws
near. Often, the current day’s candidates will be provided
intra-day via twitter “tweets.”
Richard Miller, Ph.D. - Statistics Professional, is the
president of
TripleScreenMethod.com and
PensacolaProcessOptimizaton.com.
Copyright 2006
TripleScreenMethod.com
It should not be assumed that the methods, techniques, or indicators presented
in these pages will be profitable or that they will not result in losses. Past
results are not necessarily indicative of future results. Examples presented
on these pages are for educational purposes only. These setups are not
solicitations of any order to buy or sell. The author assumes no
responsibility for your trading results. There is a high degree of risk in
trading. I am not recommending that you purchase or short stocks or options
using the techniques and methods presented in this report. Trading should be
based on your personal understanding of market conditions, price patterns, and
risk. I present here information to contribute to your understanding a
technique that has worked well for me.
